Recall Jesse wanted to explore how upside down markets manifest in corporate profit, inflation, and equity valuations.
Fiscal stimulus works through the power of government deficits. The government puts more income into the economy through spending than it takes out through taxation, causing aggregate income to rise.
So he needs to connect fiscal stimulus to income.
First, a quick aside. I find macro to feel like voodoo. The ZeroHedge crowd has been expecting hyperinflation since the GFC and Japan has acted like an alien for so long that there's a joke that goes "you are not really a macro trader unless you've lost a small fortune being short JGBs."
Jesse's approach has a notably different feel. It starts from first principles: accounting identities. Much more satisfying than the macro astrology we are used to seeing. Jesse uses the Kalecki-Levy accounting identites to derive a profit equation. This is a precise analytical relationship between govt deficits and corporate profits.
The paper walks thru this derivation in tremendous detail with supporting data and represents a standalone body of work on its own. I encourage you to give your brain some exercise and take a lap thru it.
For the purpose of this explainer we are going to skip to the rewards of the derivation:
We are able to understand:
The role the sectors play
With the Kalecki-Levi framework, we can discuss the role of sectors according to their flows.
- Households
Households are aggregate savers. Their savings fund govt and corporate deficits.
It makes sense that households are savers, while the other sectors are finance by those savings:
As actual people, households have legitimate reasons for seeking to grow wealth—they benefit from the increased security, stability, optionality, and status that additional wealth brings. The other sectors—corporations and the government—are not actual people, but rather constructs that exist to serve people. Their withholding and deficit spending decisions are not based on self-interest, but on the specific interests of the households that own them and elect them. Why do households save by withholding? Why don't they save by investing? Because opportunities for them to save by investing—for example, by starting new businesses—aren't always practical or attractive from a risk-reward standpoint. To deliver attractive returns, new investment has to be beneficial to the economy relative to its costs. But it isn't always beneficial, and it doesn't magically become beneficial simply because households want to save.
- Sovereign govts
Sovereign govts deficit spend. They are net borrowers.
In fact, sovereign govts can print money allowing them to deficit spend in a way the other sectors cannot.
So what is there constraint?
The willingness of other sectors to withhold that money! As long as there are economic participants willing to withhold the new money, and as long as the economy has the productive capacity to fulfill any additional spending that the withholding process might give rise to, economic problems such as inflation need not emerge.
4 ways economic growth can decline
- restrictive govt policy
- supply shocks These are events which interrupt an economy's capacity to produce goods and services since these are also the basis for income and spending. The interruption of supply chains or natural disasters are obvious examples
- mismatch of supply an demand Events can cause the demand for goods to become misaligned with what is available to purchase. This can also happen of demand or tastes change faster than supply. Covid has been a great example for this as travel, restauraunt, and arts and entertainment industries found themselves without customers
- financial wealth destruction This is worth a demonstration with a hypothetical example of extreme speculation. Bear with me, I'm not picking on bitcoin but will simply use the example in the paper. You could have just as easily have chosen houses or cars:
Suppose that a very large segment of the population starts speculating in Bitcoin, using leverage where available. The price rises to $10,000,000, creating enormous financial wealth for millions of people. This wealth isn't real, it isn't tied to the production of goods and services that consumers actually want to spend money on, and therefore it won't be able to generate the cash flows necessary to justify its existence or service the debt on which it was built...the system will find a way to destroy the wealth. When that happens, the unlucky people stuck holding it will be forced to reduce their spending—not because they don't want to spend, but because they can't afford to. They will have effectively given their wealth away to the people who they bought Bitcoins from. This is an example of what we can broadly term misallocation of capital if credit expansions and asset bubbles have been used to create financial wealth that is not backed by actual real wealth—the capacity to produce real things that are wanted by the economy—defaults and asset price declines are the proper remedy. The spurious wealth never should have been created and needs to be taken back. The problem with the pain experienced in these processes is that it spreads. The justified losses will depress income, spending and credit availability
Historical Case Study
What does the 20th century look like thru this lens?
The paper includes lots of charts and data but here's the gist:
- 1930s
The extreme mismatch between the desire to save and the desire to invest led to a situation in which all parts of the economy attempted to withhold income at the same time.
The Great Depressions was a spiral:
imploding vacuum—the reverse of a multiplier effect. Withholding is a zero-sum game, and other sectors in the economy, in particular the federal government, weren't engaging in sufficient deficit spending to make the game possible. By the mid 1930's, the economy had returned to growth, supported by a much stronger fiscal response. However, in 1937, the introduction of new taxes, specifically the new social security payroll tax, led to a significant drop in government deficit spending.
If the govt tries to reduce spending this requires the private sector to make up the difference but once again the private and public sectors were trying to save at the same time and the US slipped back into a recession
- WWII
Gov't was deficit spending like crazy, but this wealth injected into the system was not multiplied thru the system extensively. Why? Because as private industry shifted into war production mode the supply of domestic goods shortened. So much so that goods and services were rationed. The demand side would not have boomed anyway as many were off fighting the war while those left behind were saving given the uncertainty for their families' futures.
Note the analogy to Covid.
Despite the CAREs stimulus the opportunity to spend and travel is limited. And for many, employment conditions encourage frugality. Personal consumption expenditures dropped as the stimulus was not enough to offset the pandemic's full impact.
The analogy between Covid and WWII stimulus has a significant distinction. In the aftermath of WWII the govt reclaimed much of the wealth injection via an excess profits tax on corporations that in some cases was north of 90%. Overall there was little change to corporate profits. Whether the current govt will attempt to reclaim corporate profits is not clear.
How stimulus offsets declines
Govt deficit spending expands corporate profits which become household income.
With our understanding of how flows work, we understand fiscal stimulus via deficit spending to grow household income. The Covid stimulus is intended to bridge a hole in spending that the pandemic has punctured. It is a short-term fix and if the pandemic is not a permament fixture, the stimulus should be the right prescription.
What's the risk of stimulus?
Typical risks include:
- Moral hazard: bailing people out from consequences they should have to face. This doesn't apply to Covid since nobody did anything wrong
- Inflation: injected wealth leads to more spending than the economy can support. This risk is unlikely to materialize considering inflation was low to begin with and would have fallen from low levels if there were no stimulus.
So the typical risks of stimulus are not really in play here. It seems like a silver bullet.
If the risks of stimulus are less applicable this time, we may find ourselves normalizing reliance on it.
This is the gateway to the world of:
fiscal income targeting
The govt realizes it can spend to achieve the desired amount of growth. The govt can literally spend enough to maintain corporate profits and therefore aggregate income. Today no govt maintains such a mandate. So we should be aware of what lessons or presumptions we may mass internalize.
The nature of risk in a fiscal-targeting regime
Consider the typical risk of equity investor. In a laissez faire system without interventions, any event that depresses consumer spending is an existential, systemic risk that you cannot diversify away since equities in aggregate are a claim to that spending.
Enter fiscal targeting:
If you are a diversified equity investor, its implementation will significantly change the risk profile of your investments. The prospect of a broad decline in the incomes of the customers of your companies—a serious, unavoidable risk in the traditional laissez-faire framework—will disappear.
If stimulus manages to buoy the economy we are further cementing our reflex to be aggressively intervene.
What are the risks to equity investors in such a world?
- Households withhold (save without spending) the income that has been replaced (it's important to note that the govt can get really crazy and de-risk this as well by targeting aggregate spending instead of just aggregate income)
- Capital formation in the form of new companies being formed. These new companies would soak up these wealth injections and if you are not exposed to them your portfolio can still face downside
- Profitability: You would still be exposed to the amount of value that you manage to extract from your revenues in comparison with the value extracted by your employees, your lenders, and the governments that tax you.
The upside-down market effect
If these become the new risks investors will quickly realize a new reality. One that leads to upside-down markets where bad news becomes good news.
If the govt now seeks to replace lost spending directly thru fiscal policy (as opposed to simply incentivizing it via interest rates which were already near zero) we turn to Jesse's description:
Bad news for the economy would be good news for you as a shareholder because it would mitigate sources of risk: It would stunt new capital formation, which would mean fewer new companies to share the policy-controlled revenue pie with. It would boost unemployment and weaken the general bargaining position of labor, which would allow you to pay lower wages. Those lower wages would not feed back to you as lower spending and lower revenue because the government would effectively be insuring the economy's spending and revenue through the targeting, beefing up the very paychecks that you've trimmed down. You would therefore be free to squeeze out any untapped sources of productivity that might be latent in your operations, keeping the gains for yourself. If the contraction were to also provoke a monetary response in the form of interest rate reductions, your interest expense would decline, driving a further boost in your profitability. Finally, the likelihood of a corporate tax increase would fall as the policy bias shifts away from contractionary measures that might slow the economy down. Investors would still be exposed to the negative effects that bad news can have on investor sentiment and appetite for risk, but fundamentally, in terms of the discounted value of future earnings, bad news would be good news